Tuesday, July 20, 2010

How to Read Financial Statements – Evaluating Value Drivers and Searching in Footnotes (Part 3) - Alpha

by Alpha and Vega, an Investor and a Trader
July 20th, 2010

1) Finding the Value Drivers that Make a Business
2) The Credit Card Industry – American Express and Capital One
3) The Airline Industry – Southwest and JetBlue
4) The Cable and Satellite TV Industry – Comcast and DirectTV
5) Footnotes are like Snowflakes: No Two are the Same
Appendix: Ben Graham’s Satire on Accounting, or How to Abuse a Footnote (only in pdf version)

The first letter in the “How to Read Financial Statements” series went over basics on finding them and how to approach them. The second letter got into the guts of a 10-K, into the first level of analysis. This third letter shows how to finesse the footnotes and creatively assess the value drivers behind a business.

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1) Finding the Value Drivers that Make a Business
The million-dollar skill in reading financial statements is simplifying complexity. I’ve seen valuation analyses that fit on 25 Excel tabs, more than a hundred printed pages (murder by model). Other analyses could fit on one double-sided page. Shorter is harder and often better. KISS – Keep it simple, stupid. That is, an analyst must know how to read and understand dozens of tables of numbers, such as revenues, costs, margins, earnings, cash flows, assets, debt maturity walls, etc., to find the value drivers of a business. She must condense.

A value driver is a fundamental, causative business variable that effects accounting data (revenues, margins, earnings, cash flows, etc.). Accounting data are then used to calculate ratios to show the strength of a business and the intrinsic value (or estimated value range) of its securities. Value drivers make up the economic ghost inside the financial machine. They are the economic forces that drive financial outputs and metrics. Value drivers tend to be specific to industries or sub-industries, sometimes even specific to an individual business. Good management teams focus on value drivers; the bad teams don’t even know what they are.

Here are some examples of value drivers in different industries:
• Retail banking: At its core, retail depository banks make their profits/earnings from borrowing cheaply and lending at a higher rate. The core value driver is the “net interest margin” (NIM), a measure of the difference between a bank’s interest income and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets. NIM is usually expressed as a percentage of what the financial institution earns on loans in a time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period (the average earning assets). NIM takes both rates and dollar amounts into account, whereas the “net interest spread” just looks at the rate differential or “spread.”
• Apparel Clothing: Niche business like Polo Ralph Lauren Corp. (RL) may have many products and lines of business (basic, middle-market, premium, etc.). However, the vast majority of earnings are generated by a handful of product staples, and for RL the basic items are polo and cotton shirts, khaki pants, sweaters, and so on. While RL has many outlets, by far the most profitable are its wholesale and internet outlets. Hence a business with hundreds of products and many outlets can be simplified into: How many units of staple goods are being sold, and in what channel? Also, are the total costs of marketing worth it, and are the dud goods not eating up all the profits?
• Property-Casualty (P-C) Insurance: The basic model for insurance is to take in premiums (up front protection payments) and pay out expenses (claims for losses plus operating expenses). An insurer’s “combined ratio” is basically claims plus operating expenses divided by net premiums (this can be broken into a loss ratio and an expense ratio). However, the net premiums that insurers collect, the “float”, can be profitably invested while the company holds it. So if an insurer has positive investment returns greater than the loss from the combined ratio, it can still be profitable. To wit, an insurance company can be poor at underwriting and make up losses through good investing. A low combined ratio along with high investment returns (good use of float) is what makes a great insurer. Warren Buffett explains float well in his 2005 Chairman’s Letter in the Berkshire Hathaway annual report:

“Float” is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled.

Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an insurer earns an underwriting profit – as has been the case at Berkshire in about half of the 39 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.


Other insurance industry value drivers are: renewal rates for policy holders; the costs to acquire a new policy; and the composition/attribution of investment returns.

The second most valuable skill in reading financial statement footnotes is being able to verify/validate/examine basic accounting figures, and to catch fraud and shenanigans. This is detective work.

Some examples of why footnotes are important:
• All revenues are not equal. Some revenues are generated through cash payments, others through IOU slips call receivables which may never be paid. Footnotes discuss revenue recognition policies. Also, a company may get most of its revenues from 2-3 buyers, and this is a dangerous and unhealthy relationship (I know because one of my early, bad investments, in 2000, was in a company which derived 80% of its revenues from 4 customers, who then faced their own difficulties and stopped buying – there’s no learning that sticks better than losing money).
• Earnings may be manipulated. A company may report high earnings but a negative operating cash flow, suggesting earnings are being gamed. Enron (formerly ENE) did that for a few years, and then came up with a complicated scheme to create fake operating cash flows. Footnotes explain why reported positive earnings differ from reported negative cash flows.
• A healthy company could go bankrupt due to debt. The debt maturity wall of a healthy, levered business may signal an impending default, severely hurting unsuspecting equity holders (a healthy business may be poorly financed). In the 2008-2009 credit crunch, General Growth Properties (GGP) was a healthy mall company that had a bad financial structure, leading it into technical default. Footnotes explain the cost and timeframe for maturing debt.

This letter will look at pairs of companies in three industries: credit cards, airlines, and cable/satellite TV to further delve into the importance of value drivers and footnotes. The point isn’t to illuminate any industry in particular, but more generally to suggest how one should think about a company’s value drivers and footnotes within the context of its industry.

2) The Credit Card Industry – American Express and Capital One
American Express (AXP) and Capital One Financial Corp. (COF) are two of the largest stand-alone credit card companies in the US (if not the world). Their market caps as of early June 2010 are $46 billion and $17 billion, respectively. Credit card companies make money by borrowing money from capital markets to: i) make loans to cardholders at higher rates, and ii) hold an investment portfolio earning high returns.

The value drivers behind a stand-alone credit card business such as AMX aren’t horribly complicated:
• Spread Revenues: The company lends to cardholders and then charges them a high interest rate (in the 10% to 30% range) and also fees galore. Multiplying the spread by the size of the loan book generates most revenues. In the footnotes to AMX’s 2010 10-K on p. 51, it had interest-bearing liabilities of $79 billion, at an average rate cost of 2.8%. Roughly $24 billion was invested in investment securities (mostly state and muni debt, agencies, and USTs), yielding 4.3% on average (p. 53). Roughly $33 billion was loaned to cardholders, earning 11-17% (p. 49).
• Write-off Costs: The biggest loss is through written-off loans (and the probability that nonperforming loans will have to be written off). The operating expense of running and marketing a large card network is also high. A card company with good underwriting standards has write-offs that are less than its allowance for losses (its planning account set up to estimate write-offs). To see how much AMX is losing to writeoffs, compared writeoffs to its entire cardholder loans outstanding. The table on p. 60 shows this is a high (and unsustainable) 8.5%, much higher than previous experience of 3.5%. If AMX can only charge 11% for loans, and has to pay 2% for funding liabilities (see below), it has 9% left for write-offs and all operating expenses. So 8.5% just for writeoffs is too high (operating and marketing expenses are much more than 0.5%).
• Liability/Debt Funding Costs: Most credit card companies allow cardholders to keep a balance. The card companies therefore need to borrow money through bonds and the wholesale funding market, and they relend that out to cardholders who have a balance. In the footnotes to AMX’s 2010 10-K on p. 66, its short term borrowing fell from $17.7 billion in 2007 to $2.4 billion in 2009, as the funding markets shut down (AMX almost went bust trying to hustle and obtain longer-term funding, but TARP money from the US government helped ease the transition). Note that the cost of the short-term funding fell from 4%-5.15% in 2007 to 0.7%-1.50% in 2009. So AMX is getting cheaper money to borrow, but also much less of it. More importantly, AMX has $52 billion in long-term debt, with an average rate of 4.11%, plus customer deposits of $26 billion (cost not stated). The maturity wall of when debt comes due is put on a table in p. 96 in the portions of the annual report:

Securitization and other fee income make the AMX credit card business model more complex, but I won’t go into that now.

The value drivers behind Capital One (COF) are slightly more complicated, as it has three businesses: credit cards ($23 billion in reported loans), commercial banking ($30 billion in loans to real estate and middle market firms), and consumer/retail banking ($38 billion in loans). However, COF’s core credit card business is similar to AMX, as shown below:

• Spread Revenues: COF states metrics in the “Selected Financial Data” table, showing that the NIM is 5.3%, the net charge-off (writeoff) rate is 4.58%, and the return on overage assets is 0.58%. In the footnotes to COF’s 2010 10-K on p. 48, it had total deposits of $116bn and other borrowings of $12 billion. COF’s average revenue margin on its domestic credit card book (about $65 billion in loans) is about 15.5%, of which 12.8% comes from yield (the rest, presumably, being fees). The table on p. 82 lists the domestic yield as 10.3%, which is inexplicably lower. COF also holds about $39 billion is securities, from which its yield is 3.6% to 5.0% (pp. 118-119).
• Write-off Costs: COF’s net domestic charge-off (writeoff) rate of 9.7% is higher than AMX’s 8.5%. If you add the 30+ day performing delinquency rate of 5.9%, COF will have to writeoff nearly 16% of its total credit card loan book!
• Liability/Debt Funding Costs: The vast majority of COF’s liabilities are interest-bearing deposits, at nearly $116 billion. It also borrows another $12 billion from other sources (which COF admirably gives a full listing of the notes, with their coupon, par values, and maturity date (p. 133). The interest-bearing deposits have a very low cost of 2.0% (see footnote one to the footnote on page 133). This is the killer competitive advantage for COF, buried very deeply in its footnotes.

One can see that the credit card industry reduces to a few value drivers: the size of the loan book; the average interest rate yield and the average cost of funds; the net writeoff rate. Of course, the SG&A expense structure matters too. Next I turn to airlines.

3) The Airline Industry – Southwest and JetBlue

Southwest Airlines (LUV) and Jet Blue Airways (JBLU) are two of the largest discount airplane companies in the US, both known for their great service, innovative business models, and profitability (unlike most airlines, which are unprofitable and poorly run). The largest value drivers are:
• revenue passenger miles (the total number of revenue-paying passengers multiplied by the number of miles they flew);
• passenger revenue yield per revenue passenger mile (how much was made on each passenger for each mile they flew);
• fuel costs (average cost per gallon), which is the largest single cost for an airline;
• the load factor (how many revenue passenger miles were booked for the available seat miles that an airplane could fill, a higher number showing that an airline is operating efficiently and closer to “capacity”);
• and average fleet age (as older fleets need to be replaced sooner, at high cost, and are more expensive to operate).

Southwest, because it is so efficient, is the largest air carrier in the US (measured by the number of originating passengers boarded). It runs a point-to-point service instead of a typical hub-and-spoke service, and keeps costs down by having only one type of plane, a Boeing 737.

Southwest, being a very well-run company, prominently lists the value drivers on page 23 of its 2009 10-K.

JetBlue is also a very well run company, emphasizing high quality service (ranked the best in the US by JD Power for the last 5 years) and focus of running planes out of the New York metro market. JetBlue even states openly the nature of the industry on pages 4-5 of its 2009 10-K: “Airline profits are sensitive to even slight changes in fuel costs, average fare levels and passenger demand. Passenger demand and fare levels historically have been influenced by, among other things, the general state of the economy, international events, industry capacity and pricing actions taken by other airlines. The principal competitive factors in the airline industry are fares, customer service, routes served, flight schedules, types of aircraft, safety record and reputation, code-sharing relationships, capacity, in-flight entertainment systems and frequent flyer programs.” JetBlue has given both the value drivers and the competitive factors behind the value driver metrics. It offers the actual metrics on page 26.

JetBlue conveniently explains the metrics in detail:
• “Revenue passengers” represents the total number of paying passengers flown on all flight segments.
• “Revenue passenger miles” represents the number of miles flown by revenue passengers.
• “Available seat miles” represents the number of seats available for passengers multiplied by the number of miles the seats are flown.
• “Load factor” represents the percentage of aircraft seating capacity that is actually utilized (revenue passenger miles divided by available seat miles).
• “Aircraft utilization” represents the average number of block hours operated per day per aircraft for the total fleet of aircraft.
• “Average fare” represents the average one-way fare paid per flight segment by a revenue passenger.
• “Yield per passenger mile” represents the average amount one passenger pays to fly one mile.
• “Passenger revenue per available seat mile” represents passenger revenue divided by available seat miles.
• “Operating revenue per available seat mile” represents operating revenues divided by available seat miles.
• “Operating expense per available seat mile” represents operating expenses divided by available seat miles.
• “Operating expense per available seat mile, excluding fuel” represents operating expenses, less aircraft fuel, divided by available seat miles.
• “Average stage length” represents the average number of miles flown per flight.
• “Average fuel cost per gallon” represents total aircraft fuel costs, including fuel taxes and effective portion of fuel hedging, divided by the total number of fuel gallons consumed.

One final footnote about airlines is worth examining: their debt levels and fuel hedge books. First, airlines are highly levered businesses, in that their financial leverage is high, and their operating leverage (their ability to bring down their operating cost structure) is moderate to high. It’s a bad combination for the equity investor, as unexpected events could push companies into bankruptcy (the 9-11 terrorist attacks pushed the entire industry to the edge, and even with monies from Congress some companies filed for Chapter 11). Second, fuel hedges are important because they can save a company much money, or destroy much capital, based on prudent hedging or reckless speculating (the line between the two is thin) in the derivatives markets.
• Southwest, in a footnote buried on pages 38 and 54 lists its “Contractual Obligations” (more than $14 billion, split three ways between long-term debt, flight equipment obligations, and financing obligations). One great thing about Southwest is that most of its debt is long-term, with maturities from 2014 to 2039 (far better than many indebted companies).
• Southwest discusses its hedging strategy in the footnotes on pages 70-73. Their strategy: “Our current approach is to enter into hedges solely on a discretionary basis without a targeted hedge percentage of expected fuel needs in order to mitigate liquidity issues and cap fuel prices, when possible.” (p. 71) Economically, Southwest hedged between 23%-59% of its fuel needs from 2007-2009, making $77 million and $17 million in 2007 and 2009, but losing $104 million in 2008 (in comprehensive income).
• JetBlue lists on total contractual obligations of $11 billion, of which $5 billion is long-term debt or interest commitments, and $5.8 billion is in operating lease or aircraft purchase commitments. (p. 36)
• JetBlue claims it has a broad management/governance oversight structure for its fuel hedging program. It does not forswear trading, like Southwest, but rather states: “The Company utilizes financial derivative instruments, on both a short-term and a long-term basis, as a form of insurance against the potential for significant increases in fuel prices.” (p. 45) As JetBlue has done a poor job in hedging, it shows a negative position of $480 million in fuel derivatives and has given or pledged $510 million in cash and assets to its counterparties.

As you can see, the value drivers behind airlines are very different than those behind credit cards. Even analyzing liabilities is a different exercise, as credit card companies rely on short-term, ultra-cheap debt, whereas airline companies have mostly long term-debt, and commitments to purchase aircraft or rent large facilities that are expensive.

4) The Cable and Satellite TV Industry – Comcast and DirectTV
The cable and satellite industries sell a monthly subscription service. Cable companies can provide TV, internet, and telephony, whereas satellite companies usually just provide TV and internet. Comcast (CMCSK) is the largest cable company in the US, and DirecTV (DTV) is the largest satellite TV company (and arguably the biggest competitor to Comcast, at least in line with Time-Warner Cable, DISH, Cablevision, etc.). The value drivers behind these businesses are simple, and these include:
• What’s the total market size that a company can physically serve (due to load and infrastructure constraints)? What percentage is actually being served (the penetration rate)?
• What is the average monthly subscription fee or cash flow from each subscriber? What percentage of customers are subject to rate regulation (how easy is it to raise prices)?
• How much pricing power do the distribution companies have over the content/programming companies, who charge them top dollar for access to their product?
• How sticky is the business? Basically, what is the customer retention rate?
• What is the cost of acquiring a new customer, and is this less than lifetime total estimated value of a customer?

Instead of focusing on the many value drivers in the cable/satellite business, I shall focus on the debt, property and equipment, and legal footnotes. These are asset-heavy companies with mounds of debt – they also get sued often. Being debt-heavy is tax efficient, as the businesses have a steady, monopoly-like cash flow stream, so large of amounts of debt can be serviced, while the companies pay reduced taxes due to depreciation and the debt/interest payment tax shield.

Below are some key debt footnotes to look at:
• Comcast Debt Profile: Comcast has $28 billion of debt (almost as large as its tangible plant, below), with most maturing after 6 years ($22 billion) or 10 years ($12 billion). It has various sources of financing: a commercial paper program ($2.25 billion), a bank loan facility ($6.8 billion), lines/letters of credit ($6.4 billion), and subordinated debt. Comcast also has commitments to content creators in the form of programming license agreements that it must honor, and these add up to another $9 billion.
• DirecTV debt profile: With over $20.2 billion in total obligations, $9.1 billion is in long-term debt, $9.7 billion is in purchase obligations (for content), and the rest is mostly for capital and operating leases. Much of the long-term debt comes due from 2014-2016.
• Security ratings on the debt: DirecTV gets a stable, investment-grade rating of BBB-, Baa2, and BBB from S&P, Moody’s, and Fitch, for its sizable $8 billion of debt.
• Collar loan: DirecTV has a complicated equity collar and collar loan it set up in relation to a Liberty transaction (as presumably John Malone likes to protect his transaction values with collars).

Below are some key plant and equipment (P&E) footnotes:
• Comcast has a gross plant and equipment of $52 billion, charged $28 billion in depreciation (a stunning number!), and has a net P&E of $24 billion. The two biggest pieces are cable transmission equipment ($16 billion) and customer premises equipment ($20 billion).
• DirecTV’s biggest asset is their satellites, with a gross value of $3.2 billion and a net value of $2.4 billion.

Legal proceedings against or by a company are a final item that is required in all 10-Ks, something that most investors just don’t want to consider. Yet it is a legitimate risk:
• DirecTV is engaged in numerous lawsuits regarding intellectual property, early cancellation fees, and an inherited lawsuit against Liberty Media. None so far looks to be significant.
• Comcast is embroiled in antitrust cases, ERISA pension litigation, and so on. None so far looks to be significant.

The bottom line is that an analyst should examine the footnotes relevant to each industry and sub-industry. Debt levels don’t matter in the software industry (where most companies take little debt). It matters a lot in the cable/satellite industry, as large asset and debt loads are the norm.

5) Footnotes are Idiosyncratic
No footnote is the same. Despite clear, stringent rules from the SEC and FASB on how a 10-K should be organized and how detailed footnotes should be, accountants have creative control to jigger financial statements and bury key information in footnotes. The only way to get better at reading footnotes is to know the economics behind an industry and to read many footnotes. Thousands and thousands of them. Each year. Below are some further reading recommendations.

Three great books I suggest on reading between the lines and dissecting footnotes:
• H. Schilit, Financial Shenanigans
• K. Staley, The Art of Short Selling
• C. Mulford, Sustainable Free Cash Flow

Two books on understanding business models and industries:
• M. Porter, Competitive Strategy
• R. Suutari, Business Strategy and Security Analysis: The Key to Long Term Investment Profits

One great resource to consult regarding footnotes:

I also recommend Ciesielski’s “Accounting Observer,” but you need to subscribe to the (costly) service:

Your footnote loving analyst,


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The Puzzle of State-by-State Unemployment Rate Variance - Alpha

National unemployment is high at nearly 9.5%, but some US states are quite healthy!
The WSJ today has an excellent graphic on it:

Unemployment Rate at Highest Level in 3 Decades

State-by-State Unemployment Varies a Lot


-The Dakotas are at 3-4%!

-The agricultural Midwestern states are low too:
Nebraska at 4.8%, Iowa and (diversified) Minnesota at 6.8%.

-New Hampshire is at 5.9% and Vermont at 6% - these are healthy northeastern states.

-States with failed, subsidized industries (autos in Michigan/Indiana/Ohio) and real estate/casinos in Nevada are crushed:
13% and 14% unemployment in Michigan and Nevada.

For me, the biggest political/economic national problem in the US is JOBS. So I ask: Why is there such a huge divergence between the states?
Among big states, why are TX and NY doing well at 8%, while CA and IL are getting hurt at 12% and 10%?

Few to no economists are studying the divergences, and I think this is a fascinating and very important problem!

Can anyone send me an explanation for these data points?

Monday, July 19, 2010

Geopolitics (Part 1) - by Ari Paul

In this issue:
1) What is Geopolitics?
2) Expect the Absurd
3) Key Trends
4) US Domination
5) The Cold Skirmish

Politicians come and go, economies boom and bust, but geopolitics helps us see the forest for the trees. In this newsletter I'll provide an introduction to geopolitics and explore the key trends that defined the 20th century and will define the 21st. I'll argue that the US' global military and economic dominance will continue to grow over the next 30 years. Next, I'll examine the current "Cold Skirmish" with Russia, similar to the Cold War but more limited in scope. In Part 2, I'll explore the (potential) political disintegration of China, the rise of Turkey and Poland, and how demographic trends will lead to a reversal of immigration politics and kill off "traditional family values" for good.
Much of this newsletter is inspired by George Friedman's, "The Next 100 Years." Friedman is the CEO of Stratfor and he provides keen strategic insight.

1. What is Geopolitics?
Geopolitics is the study of...
the effects of economic geography on the powers of states.
how countries make choices.
patterns of behavior, and understanding why patterns repeat.
the world as a giant chessboard. Like pieces in a chess game, countries can't move at will, rather, they have a small range of reasonable choices.

Geopolitics is a way of describing the world that emphasizes military and economic power and sovereign states as rational actors. Both military and economic power are directly influenced by geography (e.g. defensible borders and access to shipping lanes), demography (e.g. availability of labor), and culture (e.g. xenophobia and tolerance of war casualties).
Many people were surprised that Obama has followed a nearly identical foreign policy to his predecessor, President Bush. A student of geopolitics understands that political leaders have little real power when it comes to foreign policy; they are constrained by the interests of their country, which dramatically reduces their available options.

I probably need to defend one claim in greater detail. Does military power really matter that much today? The US Navy is larger than the next six navies combined; are we wasting our money? The short answer is no. As Americans, we've been relatively immune from war on our soil for two centuries. We occupy land that is hard to attack and impossible to successfully occupy. More recently, our dominant military has extended an umbrella of peace over most of Europe (via NATO), to Taiwan, Japan, South Korea, and many other allies. Nations that were weak militarily and not under our umbrella of protection have not faired so well. In 2008, Russia attacked Georgia. Ask a Tibetan or Chechnyan if military power matters. Humanity is no more "enlightened" today than on the eve of the First and Second World Wars. Nations reasonably believe that without sufficient military power, their national security is at risk.
Military power is about the projection of force. During the Cold War, Russia had a powerful army but lacked the ability to transport it; as a result, the US was unable to conquer Russia but could easily contain it by controlling major ports. The US Navy currently controls every major ocean and sea around the world. Every shipping vessel that leaves a port anywhere in the world does so with US knowledge and tacit permission. Our dominance of the oceans gives us dominance of the air via aircraft carriers. This means that the US, and only the US, is capable of waging a major war across continents.
National defense is quite a bit easier than the projection of force. An airplane can easily cross mountain ranges, but tanks and troops cannot. Natural boundaries like mountain ranges, seas, and jungles remain near-impassable obstacles for armies. Many wars are fought to gain control of natural boundaries so that a country can be safer from invasion (e.g. Russia in the Caucasus)

2. Expect the Absurd
In 1900, the Russian Empire, German Empire, and Ottoman Empire, were powerful players on the world stage. Many European elites believed that war in Europe was impossible because of the interdependent economies. Just 20 years later, Europe faced a devastating world war and the three great empires lay in ruins.
In World War II, Germany and Japan were decimated and their economies obliterated. Just 35 years later they were the 2nd and 3rd largest economies in the world.
Think of 1980. The mighty US had been defeated by communist North Vietnam. The Soviet Union threatened world domination. By 2000, the Soviet Union had collapsed completely and NATO had even expanded into Eastern Europe. "Communist" China was one of the
These examples should demonstrate that the big problems of the day are frequently irrelevant in 20 years. Empires can rise and fall with staggering speed. Most importantly, the consensus can be very wrong.

3. Key Trends
If the big issues of the day often ending up being irrelevant, to what should we pay attention? We need to identify the handful of new trends that will provoke global change. Once we have identified the trends, we can estimate their effects by applying a geopolitical lens to understand how nations will react to changing circumstances. Before I start, let me again give credit to George Friedman who provided many of these ideas.

In the 20th century, the three key themes were:
1. The quadrupling of the world's population. Agricultural technology and transportation infrastructure increased food production and allowed food to be shipped great distances. Better medicine for young and old decreased infant mortality and increased life expectancy. The primary effect of the population boom was to cause tremendous global economic growth with cheap labor and a constantly growing number of consumers. As populations exploded, access to land and resources became more important.
2. The collapse of the European Imperial System. The birth of a modern Germany and Italy in the 19th century set the stage for power struggles in the 20th. As the UK, Spain, and France lost their empires and weakened, Germany and Italy sought greater power in Europe. The result was two world wars.
3. Technology. There was a transportation revolution in the first half of the 20th century, and a communications revolution in the second half. Technological advances allowed labor productivity to rise at tremendous rates. One effect of these technological revolutions were that Japan, with no natural resources and little land for population growth, became the second largest economy in the world.

Analyzing the past is relatively easy compared to predicting the future. So what are the Key Trends that will define the 21st century?
1. Complete US domination. I'll discuss this at length in the next section.
2. The End of the Population Boom. The global population quadrupled in the 20th century and will likely be unchanged in the 21st. More dramatically, the populations of Europe, Russia, and Japan are collapsing. A shrinking population produces huge problems. The most obvious is the issue of growing entitlements supported by fewer tax paying workers. However, another major dynamic is that aging retirees will continue consuming, but there will be far fewer laborers to produce. This generally results in labor inflation. The US will face a similar, but much milder demographic crunch. I'll explore the political and economic effects of this in my next newsletter.

4. US Domination
US geopolitical power is unprecedented in world history. As I discussed in the first section, the US has complete control over the oceans, which means it dominates the globe both militarily and economically. The global economic system is the US economic system. Only a handful of countries choose not to participate and things don't go well for them - take a look at North Korea.

Second, the US outperformed other developed nations for reasons that will continue to lead to its future outperformance. For the last 500 years, the Atlantic Ocean was the avenue of world trade. Trade between Europe and the rest of the western hemisphere defined most of global trade. Around 1980, transpacific trade surpassed transatlantic trade. North America is ideally situated to profit from both transatlantic and transpacific trade. The fastest growing nations are in Asia today so Pacific trade is likely to continue growing faster than Atlantic trade. This means that US growth will likely continue to outperform European growth. Another advantage we have is demographic. The USA remains underpopulated and with easy access to new immigrants from Mexico. In contrast, Japan is facing demographic collapse with no good solution.

Third, our sovereign debt levels are relatively low, compared to other large economies. The US is in better shape than most of the EU and Japan. As money flees those regions, it has to go somewhere. UK, Eurozone, and Japanese debt holders are likely to continue shifting their money into US bonds. In other words, even though our debt levels are high and rising, they are relatively attractive compared to most of the other biggest debt issuers around the world. We may look back on this global crisis as the final transition from a European centered world, to a North American centered world.

Fourth, the upstarts are not doing as well as people think. China's growth in the last decade is reminiscent of Japan's in the 1980s. They've been growing by keeping savings artificially high, interest rates artificially low, and using that cheap money to make artificially cheap loans to companies. Municipalities and banks are accumulating bad loans. It's impossible to come up with accurate estimates, but some smart analysts are guessing that 35% of Chinese GDP is bad debt that will be written off. I think China is likely to do quite well over the next 30 years, but their growth will slow considerably, and they fill face major setbacks like everyone else. In the shorter term, their credit bubble will burst and cause a recession. India's problems are of a different nature. India is one of the most unequal economies in the world, and that tends to produce serious political problems. They are facing double digit inflation. Their worst problem is a political culture of red tape. Starting a company in India is incredibly difficult. Lawsuits, both criminal and civil, routinely take a decade to make their way through the court system. A significant portion of Brazil's growth has come directly from exporting commodities to China. As Chinese demand for infrastructure building wanes, so will Brazil's growth rate.

The economic fate of countries will depend on their relationship with the US. If the US "blesses" a country with technology transfers and special terms of trade (e.g. Israel and Turkey), that country is likely to grow faster than its peers. Similarly, if the US decides to sanction a country (e.g. Iran), it will underperform.
Our position as sole global superpower means that other countries will continue to subsidize our interest rates by buying US bonds and holding US dollars. It also means that the US is likely to remain a breeding ground for international competitive companies.

5. The Cold Skirmish
It's easy to dismiss Russia as irrelevant today, but that would be a huge mistake. Russia has far more power than appears at first glance and they are using that power aggressively.

As the major natural gas exporter to Western Europe, Russia has the power of the pump and are using it to serve their geopolitical aims. In 2007, Russia turned off the Druhzba pipeline over a dispute with Belarus; that pipeline is a major supplier of crude oil to Germany. In 2009, Russia shut off a natural gas pipeline that supplied much of Western Europe in a dispute with Ukraine. By flexing its muscle, Russia demonstrated to Western Europe that they have the power that comes with being a primary source of natural resources, and they are willing to use that power aggressively to pursue geopolitical goals. Russia's control over European energy is a major reason why Europe just sat on the sidelines as Russia invaded Georgia in 2008.

Geographically, Russia is in terrible shape. The Soviet Union had excellent defensible borders. They had the Caucasus Mountains to the south, the Carpathian Mountains to the west, and large tracts of inhospitable land to the east. Now Russia is exposed on its southern and western flank. They're scared and they want to gain defensible borders as soon as possible.

In 2005, Ukraine was on track to join NATO. NATO arose to contain (and potentially go to war with) Russia. The Russians could not allow Ukraine, which shares a border with Russia, to join NATO. They used their intelligent services to politically infiltrate Ukraine and by 2006, NATO membership was off the table. By infiltrating Ukraine and maintaining control over Belarus, Russia mitigates its problem in the Carpathian Mountains to the west. To deal with the Caucasus exposure, Russia attacked Georgia and occupied Chechnya despite great cost.

Unlike in the Cold War, Russia is not competing with the US for global domination. Russia just wants defensible borders, which requires domination of central Eurasia. The flash point is likely to be the Baltics.
Latvia, Lithuania, and Estonia are too close for comfort, and they're NATO. If Russia threatens these countries (either with covert ops, a troop buildup, or barricading their imports/exports), will NATO react? Germany does not want to get involved in any kind of confrontation with Russia and they will feel safe with Poland as a buffer. If Germany blocks NATO action, NATO could dissolve. Alternatively, the US could find a political solution that allows it to pour money and defenses into the Baltic countries without explicitly calling on and perhaps fatally testing NATO support.

Geopolitics is just one lens, but it is a highly useful tool in trying to predict the future actions of countries. In the next installment, I'll apply the geopolitical lens to China, Turkey, Poland, and the Islamic world.

Your "Born in the USA" trader,

Wednesday, July 14, 2010

Is Deflation the Bigger Risk with the Money Supply Falling? - Alpha

Disinflation (inflation going lower) or outright deflation (prices falling) seem to be the bigger threat over the next 2-4 years.

Basically, when a society is so indebted that everyone must save more, consume less, and pay off debt, deflation is a bigger risk than inflation. Much of the Western World is in that situation.

In the US, the money supply is a key leading indicator for potential inflation or deflation. The Fed, for various reasons, no longer publishes M3, a broad definition of the money supply. It stopped in 2005, as the bubble took off.

For more on the money supply, see: http://en.wikipedia.org/wiki/Money_supply

For more on why the Fed stopped publishing M3, see their two explanations:


However, private sector companies that calculate/estimate economic figures(Capital Economics and ShadowStats) suggest that M3 has contracted since June 2009, by about 5.4% over the last year (June 2009 to June 2010).

Private Sector Forecasters Show M3 (A Broad Money Supply Indicator) is Falling

It looks like the Fed is taking a page out of the failed BOJ deflation playbook out of the last 20 years, despite Bernanke’s speech suggesting the contrary: Bernanke's Speech in 2002 after the DotCom Bust's Deflation Scare

The more thoughtful members of the Fed Board think deflation and a slowing economy are a much bigger risk than high inflation and an overheated rebound. The President of the Boston Fed said today:

“The core inflation rate is right around 1%. Given the amount of substantial excess capacity that we have in the economy, there is some risk of further disinflation. And I would say the risk of deflation has gone up and is more of a risk than I would like to see at this point.

“We’re seeing core prices continuing to decline in Japan. We’re seeing some of the peripheral [European] countries like Ireland starting to see actual declines in prices as a result in part of a fiscal austerity. We have a number of other countries in Europe that are about to embark on a substantial fiscal austerity. We don’t want to be in a situation where countries other than Japan start worrying about deflation.

“We have plenty of tools to tighten up if it turns out the economy grows faster and inflation becomes more of a concern. But it is a little uncertain how effective our tools are once the economy gets into a deflationary environment. The experience of Japan is sobering. They’ve spent a decade and a half dealing with an economy that has had falling prices and despite a variety of monetary and fiscal actions taken are still facing a deflation problem.

“It just highlights that it is not straightforward for policy makers to break out of a deflationary environment. And so if you were to look at the balance of risks and what we could do about those risks, the risk from a downside shock I would view as more of a problem than the risk of an upside shock of inflation or to the economy overall.”

See the whole interview (very informative) at the WSJ Blog here: Full Boston Fed Rosengren Interview.

Again, if the money supply keeps contracting at this rate, it eventually has to lead to deflation, which can be a trap once it gets anchored into consumer expectations.

Fiscal Tightening - A Nasty Surprise? - Alpha

The world will begin its largest real-time experiment testing the ideas of two dead economists. I feel deeply uncertain about the outcome, as things could get nasty.

The big policy question today: Are governments removing stimulus policies and tightening too quickly?

-The 1930's Lesson: FDR made this mistake in 1937 (after reflating the economy in 1932-35), in response to budget/debt hawks, causing the second Great Depression (there were two depressions in the 20th century, one from 1929-1932, the other from 1937-1938). See: http://en.wikipedia.org/wiki/Recession_of_1937%E2%80%931938

Christina Romer, now a top Obama economics advisor, explains the lessons from the 1930s here: Romer Speech on the Depression

-PRO Spending (The economist Keynes' view): If governments remove stimulus spending too early (by cutting spending and raising taxes), when confidence is low, unemployment high, and factory utilization capacity low, it could plunge the world into depression again. Right now, governments are the only entities that can keep demand and the economy up, and they should counter debt deflation (when people just save and pay off debt, hurting the economy) by spending. Otherwise, the world will go into a vicious cycle, confidence will go down as unemployment gets worse, and the world will reach a bad economic equilibrium point.

Paul Krugman explains the logic of a "spend more, cut later" view in simple terms in two editorials:


Also the FT's Martin Wolf gives more nuanced detail here on why monetary and fiscal stimulus must continue: http://www.ft.com/cms/s/0/fc8d1dd4-78b6-11df-a312-00144feabdc0.html


-CONTRA Spending (The economist Hayek's view):
If governments spend too much and build up deficits, it makes the economy structurally uncompetitive and leads to the long term mis-allocation of resources, not to mention strange boom bust cycles (and it supports failures and penalizes the successful, with the banking bailouts being a perfect example). There is also a risk of debasing all the major global currencies, which would have deleterious effects.

Or as Keynes himself put it:
"The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."

Also, countries that overspend can get stuffed with too much debt, and they can go bust like Greece recently did, in a nasty way. So the best view is to tighten and let natural forces of austerity, default, and unemployment take hold. This view is actually quite similar to Treasury Secretary Mellon's view in the US in 1930 (leading to the Great Depression):

"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate."

Many argue that it made the Depression worse (some argue it was worse in the short run, but healthier/better in the long run). The austerity hawks point out that Japan's massive fiscal and monetary stimulus after 1990 didn't help, but that may be an incorrect analysis, as Adam Posen discusses here: Posen BoE Speech

Today, the data seems to suggest that most developed country (OECD) governments are tightening. Germany is taking the lead with the most draconian austerity measures, showing discipline. The US is the exception because economics advisors Summers and Romer seem to have convinced President Obama that stimulus now is better - note, the only US deficit hawk in the govt,. Paul Orszag, resigned this week. One interesting analysis from Bob Davis of the WSJ:

"Essentially, the world’s two largest economies — the U.S. and the EU –are addressing their biggest current and historical fears. For the U.S., that’s a repeat of the mistakes of the Great Depression when Presidents Hoover and then Roosevelt withdrew stimulus too soon, which prolonged and deepened the downturn. For Europe, it’s a fear of repeating the mistakes that produced the hyperinflation of the 1920s which gave rise to Nazism, added to the current fear of repeating the problems of Greece, which teetered on the edge of debt default before an EU-International Monetary Fund rescue package was approved. Hence, the European focus on austerity."


Western world cuts back spending: http://www.ft.com/cms/s/0/aaa8ffc2-7e2b-11df-94a8-00144feabdc0.html
Europe tightens fiscal policies: http://www.ft.com/cms/s/0/9acbb194-5eaa-11df-af86-00144feab49a.html
German finance minister explains austerity and scolds the US: http://www.ft.com/cms/s/0/9edd8434-7f33-11df-84a3-00144feabdc0.html

UK presents extreme budget cuts: http://www.ft.com/cms/s/0/0db4130a-7c8c-11df-8b74-00144feabdc0.html
Canada cuts spending: http://www.ft.com/cms/s/0/2c15e9fc-7bc1-11df-aa88-00144feabdc0,s01=1.html
Japan begins to cut spending and stabilize debt: http://www.ft.com/cms/s/0/b10c1e24-7dab-11df-a0f5-00144feabdc0.html
The US is still trying stimulus measures: http://www.reuters.com/article/idUSTRE64F21Q20100516

The new head of ECB/EU monetary policy likely will be Axel Weber, a strict hawk more concerned about inflation that employment:

I don't know which economic worldview is correct, but I have an uneasy feeling about how this will end.